The economics of offsets defence procurement and coutertrade

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THE ECONOMICS OF
OFFSETS


Studies in Defence Economics
Edited by Keith Hartley and Nicholas Hooper, Centre for Defence Economics,
University of York, UK.

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This monograph series adopts a wide definition of defence economics to cover all aspects
of the political economy of defence, disarmament and peace.
Volume 1

European Armaments Collaboration: Policy, Problems and Prospects
Ron Matthews

Volume 2

Military Production and Innovation in Spain
Jordi Molas-Gallart

Volume 3

Defence Science and Technology: Adjusting to Change
edited by Richard Coopey, Matthew Uttley and Graham Spinardi

Volume 4

The Economics of Offsets: Defence Procurement and Countertrade
edited by Stephen Martin

This book is part of a series. The publishers will accept continuation orders which may be cancelled
at any time and which provide for automatic billing and shipping of each title in the series upon publication. Please write for details.


The Economics of Offsets
Defence Procurement and Countertrade

Stephen Martin
The Centre for Defence Economics
University of York, UK

LONDON

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Edited by

~ ~~o~!~:n~~~up

LONDON AND NEW YORK


Copyright © 1996 by OPA (Overseas Publishers Association) Amsterdam B.V.
Published by Routledge

2 Park Square, Milton Park, Abingdon, Oxon, OX14 4RN
270 Madison Ave, New York NY 10016

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Transferred to Digital Printing 2007
All rights reserved.
No part of this book may be reproduced or utilized in any form or by any means,
electronic or mechanical, including photocopying and recording, or by any
information storage or retrieval system, without permission in writing from the
publisher.

British Library Cataloguing in Publication Data
Economics of Offsets: Defence Procurement and
Countertrade. - (Studies in Defence
Economics, ISSN 1062-046X; Vol. 4)
I. Martin, Stephen II. Series
382
ISBN 3-7186-5782-1

Publisher's Note
The publisher has gone to great lengths to ensure the quality of this reprint but
points out that some imperfections in the original may be apparent


Contents
vii

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Acknowledgements
1

Introduction and Overview
Stephen Martin

2

Countertrade and Offsets: An Overview of The Theory and
Evidence
Stephen Martin

15

3

The Defence Offsets Policy in Australia
Stefan Markowski and Peter Hall

49

4

Offsets and Weapons Procurement: The Belgium Experience
Wally Struys

75

5

In Search of a Strategy: The Evolution of Canadian Defence
Industrial and Regional Benefits Policy
James Fergusson

107

6

Offsets and French Arms Exports
Jean-Paul Hibert

139

7

Offset Benefits in Greek Defence Procurement Policy:
Developments and Some Empirical Evidence
Nicholas Antonakis

1

163

8

Defense Industrialisation Through Offsets: The Case of Japan
Michael W Chinworth and Ron Matthews

177

9

Saudi Arabia and Offsets
Abdulla M. Al-Ghrair and Nick Hooper

219

10

The Teeth of the Little Tigers: Offsets, Defense Production and
Economic Development in South Korea and Taiwan
Dean Cheng and Michael W Chinworth

245

11

From Offsets to Industrial Cooperation: Spain's Changing
Strategies as an Arms Importer
Jordi Molas-Gallart

299

12

US - Swiss F-5 Transaction and the Evolution of Swiss Offset
Policy
Bernard Udis

321

13

The UK Experience with Offsets
Stephen Martin and Keith Hartley

337
v


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vi

CONTENTS

14

US Offset Policy
Bernard Udis and Keith E. Maskus

357

15

The Business of Offset: A Practitioner's Perspective
Case Study: Israel
Alon Redlich and Maison Miscavage

381

16

Concluding Remarks
Stephen Martin

407

Index

411


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Acknowledgements
The preparation of this volume was funded by the Economic and Social
Research Council (R000233146). The editor would like to thank all those who
have assisted in the publication of this book. Thanks are due to Professor Keith
Hartley, who read and commented upon the manuscript, and to Roberta
Blackburn and Margaret Cafferky, who provided excellent secretarial and editorial assistance in the final stages of publication.

vii


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List of Contributors

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Abdulla M AI-Ghrair, BS King Faisal Air Academy, MDA Cranfield, Brigadier
General, Royal Saudi Air Force, pilot. His research interests include economic
offsets, Saudization and conflict resolution.
Nicholas Antonakis has a PhD in Defence Economics from the University of
Athens. He is an expert economist in the Greek Ministry of Industry, Energy
and Technology. His research interests include the determinants and growth
effects of military expenditure, and the structure and performance of defence
industries.
Dean Cheng has worked for several years as a researcher and writer on Asian
defence and foreign affairs. He is completing his dissertation, which examines
Asian perceptions of the United States and Japan in the post-World War II era.
He lives in Washington, DC.
Michael Chinworth is the Senior Analyst of Asian Technology for The Analytic
Sciences Corporation of Arlington, Virginia. He has published widely on the
technological capabilities of the Far East, including Inside Japan's Defence:
Economics, Technology and Strategy (published by Brassey's (US) in 1992). He
writes a monthly column on Asian science, technology and business trends in
Automotive Engineering (published by SAE International)
Dr James Fergusson is the Deputy Director of the Centre for Defence and
Security Studies at the University of Manitoba, Winnipeg, Canada. He has written extensively on issues related to Canadian defence industrial policy and practices, and is currently examining the defence industrial implications of Canadian
participation in Ballistic Missile Defence.
Peter Hall has a long standing research interest in industry economics and, in
particular, in the economics of technological innovation. This culminated in his
book Innovation, Economics and Evolution, published in 1994, which has also
led to specialist work in defence industry economics. He has recently been one
of the leaders of a major government inquiry into R&D activity and policy in

Australia.

ix


x

LIST OF CONTRIBUTORS

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Keith Hartley is Professor of Economics and Director of the Centre for Defence
Economics, University of York. He has continuing research interests in defence
economics, including procurement policy, the Single European Market for
defence equipment and various aspects of disarmament.
Jean-Paul Hebert has a PhD in economic theory and is a member of the
Defence Sociology group in the Ecole des hautes Etudes en Sciences Sociales
(GSDIEIIESS, Paris). He is a specialist on the French armaments industry and
his latest book is Production d' Armement, Mutation du Systeme Fran~ais,
Editions de la Documentation Fran~aise, Paris, 1995.
Nick Hooper is currently Deputy Director of the Centre for Defence Economics
at the University of York. Previous appointments included Industrial
Development Analyst for Aramco from 1982 to 1985. His current research interests include defence industries, procurement policy and industrial and manpower
adjustment to reductions in military expenditure.
Dr Stephen Martin is a Research Fellow in the Centre for Defence Economics
at the University of York. His current research interests include the economics of
defence procurement and the impact of privatisation on corporate performance.
Stefan Markowski is the convenor of the postgraduate Management Studies
Program for the Australian Defence Force Academy at the University of New
South Wales in Canberra. His research interests include applied microeconomics, in particular defence economics, and operations and logistics management. He has also been retained by a wide range of private and public sector

clients, including the Australian Defence Organisation, as an economic and management consultant.
Keith Maskus is an Associate Professor of Economics at the University of
Colorado (Boulder). He received his PhD from the University of Michigan in
1981. His research interests lie in empirical modelling of trade theories and in
aspects of multilateral trade policy. Recently he has devoted considerable attention to the economics of international differences in intellectual property rights
regimes.
Ron Matthews is a senior lecturer in economic and financial management at the
School of Defence Management, Cranfield University. He has research interests
in technological offsets and defence industrialisation and is the author of numerous articles on these related subjects. He is also the co-editor of a recent book,
entitled Japan's Military Renaissance, published by Macmillan.


L~TOFCONTRmUTORS

Xl

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Maison Miscavage is the Projects Coordinator at International Technology
Sourcing Inc. His responsibilities include project research and structuring, as
well as competitive analysis. He also takes a special interest in Russia and FSU
affairs.
Dr Jordi Molas-Gallart is an economist working as a Research Fellow at the
Science Policy Research Unit, University of Sussex. His doctoral dissertation,
Military Production and Innovation in Spain, has been published by Harwood
Academic Publishers.
Alon Redlich is the President of International Technology Sourcing Inc (ITS), a
Chicago-based company engaged in the development and implementation of offset strategies. Mr Redlich and the ITS team serve as strategic planning and business development advisors to numerous Fortune 100 companies. He is currently
focusing on initiatives in Russia, India, Israel and the UAE.
Dr Wally Struys is head of the Department of Economics and Management and

Professor of Economics at the Royal Military Academy (Brussels). His research
activities and publications lay mainly in the field of Defence Economics. He
participates in several working groups dealing with defence matters in NATO,
WEU and UE. He is a founding member of the International Defence
Economics Association (IDEA).
Bernard Udis is a Professor of Economics at the University of Colorado
(Boulder). He was awarded the PhD degree by Princeton University in 1959.
Interests cover defense economics, labour economics, industrial policy, technology transfer and international economic policy. His most recent research examines the costs and benefits of offsets in defence trade and the possible role of
Japan in a future military technical revolution.


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Chapter 1

Introduction and Overview

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Stephen Martin
Centre for Defence Economics,
University of York, UK
1.1

Context

Defence procurement can take a number of forms. From indigenous projects,

through shared development and production, licensed production and offsets, to
an off-the-shelf purchase of a foreign design. Each form of procurement offers
the purchaser a different degree of industrial involvement with the development
and production of the system being acquired. At one end of the spectrum lie offthe-shelf purchases of a foreign system: these yield neither development nor
production work for the domestic defence industrial base (DIB). At the other
extreme lies indigenous development and production where all work is allocated
to domestic firms. Between these two extremes are procurement options where
work is shared between vendor and purchaser.
When purchasing defence equipment, vote-sensitive governments face some
difficult choices. Indigenous development and production will, theoretically,
provide an independent capability, the required equipment, as well as the most
benefit for the domestic economy in terms of jobs and technology acquisition.
However, this is also likely to be the most expensive option. An off-the-shelf
purchase might involve compromise over the system's capability and will generate little domestic economic benefit. Moreover, there is always the risk that a
vendor will not be willing/able to deliver further supplies as and when these are
required. Yet this is likely to be the cheapest procurement option.
The ever-increasing costliness of defence equipment, limited defence
budgets, as well as concerns about unemployment levels and the competitiveness of domestic industry, have all encouraged many states to eschew both
indigenous development and off-the-shelf purchases. Instead, governments have
favoured procurement forms which yield benefits for the domestic economy as
well as being less costly than an indigenous programme. One option, which has
been pursued by the larger Western European nations, has been to collaborate in
the development and production of new equipment.! This has been particularly
common for aerospace products, such as aircraft and missiles, where collaboration, by eliminating the duplication of costly R&D, can offer substantial savings
over an indigenous programme. 2
1


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2

THE ECONOMICS OF OFFSETS

For some products, collaboration is not possible (e.g. where no other state
has a similar requirement) or is considered too costly relative to the usually
much cheaper off-the-shelf import option. However, imports typically bring few
industrial benefits to the purchaser's economy. As a compromise, many countries have sought other procurement methods which ensure that each major
defence procurement contract placed with a foreign supplier also provides substantial industrial benefits for the purchasing nation. These benefits are often
discussed under the umbrella term 'offsets'. To the uninitiated, this can be confusing because the term 'offset' is also used to describe one particular form of
industrial benefit. In this book, the broad definition of offset is adopted and this
is taken to include the following forms of industrial benefit: co-production,
licensed production, direct offset and indirect offset.
Licensed production occurs where the purchaser obtains a share of the production work for its own order and, sometimes, for its own exports to third
parties. The licence may cover the manufacture of the entire item or only specified parts. Sometimes the licence only covers final assembly. Both Italy (Agusta)
and the UK (Westland) have frequently purchased licences to produce
American-designed helicopters.
Similar to licensed production is co-production, where the nation buying a
foreign design is given a share in manufacturing work for its own order, the
designer's order, and orders from third parties. For example, the General
Dynamics F-16 European co-production contract in 1975 was based on sharing
the manufacture of a 998 aircraft programme. The European consortium, which
ordered 348 aircraft, was allocated work on the following basis: ten per cent of
the initial US order (650 aircraft), forty per cent of their own order and fifteen
per cent of export sales to other countries. Exports were estimated at 500 units
and achievement of this figure would have meant that the Europeans would have
obtained manufacturing business to the value of 80 per cent of their total order,
namely 279 aircraft. 3
While both co-production and licensed production provide employment and
technological benefits for the domestic economy, the establishment of an indigenous production line is 3. costly business. As defence budgets have been cut and

unemployment has risen, purchasers have sought a less costly form of procurement which still generates work for the domestic economy. Typically, this
obliges the foreign vendor and its sub-contractors to buy goods and services
over and above what it would have bought from firms in the purchaser's
economy. This offset is usually some percentage of the contract price and a time
period is often set for its fulfilment. Restrictions are usually imposed on the type
of goods eligible for inclusion towards the offset, and certain types of work (e.g.


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INTRODUCTION AND OVERVIEW

3

R&D) might be weighted more heavily than other purchases (e.g. off-the-shelf
purchases of manufactured goods). These offsets might be for items to go into
the equipment that the purchasing state's defence ministry is buying, in which
case they are known as direct offset, or for items totally unrelated to the actual
equipment being purchased, which is termed indirect offset. If the industrial base
in the country purchasing the equipment is relatively small and underdeveloped,
there may be few goods that can be purchased and thus inward investment might
constitute the major component of any offset programme (e.g. as in the recent Al
Yamamah sale of military aircraft by British Aerospace to Saudi Arabia).
Drawing hard and fast boundaries around the forms of work-sharing is not
always either useful or easy. For example, there are obvious similarities between
the licensed production of an aircraft part which is to be included in the aircraft
to be purchased, and the production of the same part which is eligible towards a
vendor's (direct) offset obligation: in both cases the work is placed with the
domestic manufacturer. There are, of course, also differences: the direct offset
implies that domestic manufacturer already had access to the necessary technology whereas licensed production implies the transfer of new technology to the

manufacturer.

1.2

The Need for a Comparative Volume

All governments purchase defence equipment and it is, therefore, hardly surprising that over 130 countries have some form of offset policy.4 Although commonplace, offset requirements vary considerably from one country to another
(e.g. in terms of the type expenditure that is offset eligible). Moreover, states
vary in terms of how long they have had an offset requirement and thus some
policy differences will reflect their different experiences. Other policy differences will reflect different objectives (e.g. an emphasis on production or R&D
work). This international diversity makes for an interesting comparative study.
Furthermore, as a specialism, economists have long neglected defence
matters although the level of resources devoted to defence spending and indeed
offsets is such as to warrant a substantially increased research effort. Certainly,
there are very few economic evaluations of offset programs, not least because of
the considerable problems associated with such an exercise. First, there is little,
if any, routinely published data. Hence the analyst is reliant on the goodwill of
those in industry and government to discuss such matters. Second, offsets are
big business and are thus commercially sensitive. In an era of high unemployment, vote conscious governments are sensitive to the charge of spending large


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4

THE ECONOMICS OF OFFSETS

amounts of tax-payers' money on products that generate few domestic jobs. One
response to this is to cite the number of jobs created by offset work.
Nevertheless, governments remain vulnerable to criticism of the efficacy of their

offsets policy which is thus a politically sensitive issue. Third, those involved
with offsets in both industry and government have vested interests. Consequently, it is sometimes difficult to disentangle fact from fiction. One of the
advantages of a comparative volume is that, although the effect of offsets might
be rather difficult to elucidate for any individual country, taken together, the
experience of a number of states might more clearly reveal a number of common
themes.
Finally, as defence budgets are cut and competition in the industry
increases, offsets are likely to become more rather than less important. Firms
will seek to compete for contracts by offering increasingly attractive offset packages and purchasers will increasingly demand domestic benefits for their
defence expenditures. Thus a sound knowledge of the cost and impact of offsets
becomes even more critical.

1.3

The Approach

The original aim of this volume was to provide an authoritative account of offset
policy and experience across a representative cross-section of countries. The
achievement of this objective was constrained by the availability of economists
who were willing and able to write on offsets. However, an even more binding
constraint proved to be the availability of appropriate information and, in particular, data on the cost and impact of offsets.
With regard to giving and receiving offset work, each country can be allocated to one of three groups. First, there is the USA that largely exports equipment and thus only gives offset. The chapter on this country examines the
development of US offset policy over the past two decades. Second, there is the
small number of states that both import and export armaments and thus who
both give and receive offset work. France, Germany and the UK are three countries that fall into this category, two of which provide case studies for this book.
Finally, there is the large number of states that largely import defence equipment
and who thus typically only receive offset work.
The last group of countries offers a wide choice of case studies and an
attempt has been made to select a representative sample in terms of geographical
location, industrial base and defence policy. Four countries with a welldeveloped defence industry were selected: Australia, Belgium, Canada and

Switzerland. Even within this group, however, there is a considerable diversity


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INTRODUCTION AND OVERVIEW

5

of offset experience and policy. In Belgium and Canada, for example, there are
strong regional issues so that the Federal government is as concerned with the
geographical distribution as well as the level of offset work. Similarly, the group
is far from homogenous in terms of defence policy. Canada can, for example,
free-ride on the USA for its defence while Switzerland pursues a policy of independent neutrality.
Two other European states were selected, both with developing defence
industries. Greece provides an interesting case study because the Turkish invasion
of Cyprus in 1974 prompted a re-evaluation of the importance of its indigenous
defence capabilities. Similarly, over the past two decades, Spain has been seeking
to modernise its defence forces and both nations have attempted to use offsets to
improve their defence industrial bases. In addition, both countries have made substantial defence purchases and their respective offset policies have changed
markedly from one purchase to another. This suggests that their experience can
offer useful insights into the operation and effectiveness of offset programmes.
From the Far East, three countries are studied: Japan, South Korea and
Taiwan. All three are similar in the sense that their offset policy has emphasised
technology transfer rather than merely production work. Consequently, their preferred offset option has been to licence produce US-designed aerospace products. However, this is a particularly costly option and one which the US
government has become increasingly reluctant to permit for fears that its competitive advantage in aerospace will disappear as these transfers create new competitors in world markets.
From the Middle East there are chapters on Israel and Saudi Arabia. The
Israeli chapter is unique in the sense that it is written by practitioners rather than
academics. The authors work for International Technology Sourcing (ITS), a USbased firm that specialises in identifying offset opportunities that are mutually
beneficial to both the client country and the defence contractor. ITS has recently

completed an offset campaign in Israel, and the authors discuss their experiences
there. Three very large defence purchases over the past decade and a shift in
offset policy make Saudi Arabia an interesting case study. In addition, the Saudi
emphasis in its offset policy is not on providing work for domestic industry
(which is very small) but rather on encouraging western companies to form joint
ventures with Saudi partners to reduce the economy's dependence on oil. Like
Japan, South Korea and Taiwan, the emphasis is on technology transfer but in
the Saudi case this is neither focused on the aerospace industry nor does it
involve the licensed production of the item being procured.
Obvious gaps in this study are the omission of any countries from either
South America or Africa. These were areas where the availability of authors constraint bit particularly hard.


6

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1.4

THE ECONOMICS OF OFFSETS

Overview

Chapter 2 provides a theoretical and empirical overview of offsets associated
with both civil and military purchases. This should enable the reader to place
each of the subsequent country studies within the wider context of reciprocal
sales agreements as a whole.
Stefan Markowski and Peter Hall (Chapter 3) provide an interesting historical perspective on, and critical evaluation of, Australian offset policy. Their
chapter also admirably demonstrates the terminological minefield that bedevils
any international comparative discussion of offsets! As noted above, offset can

either be used as an umbrella term for several forms of work-sharing or as a
form of work-sharing in its own right. With regard to the latter usage, typically
two forms of offset are distinguished, direct and indirect offset. In Australia, the
term offset refers to indirect offset whilst the Australian equivalent of direct
offset is known as 'local content' (which is not discussed). The authors argue
that:
•
•
•

(indirect) offsets are not costless;
the purchaser should seek quotes for various levels of offset;
the evidence suggests that (indirect) offsets have had limited success in
either enhancing the DIB or improving the competitiveness of Australian
firms in world markets.

Hence Markowski and Hall welcome the very recent policy changes whereby
(indirect) offsets become a mechanism of "last resort". However, this should not
be interpreted as signalling the demise of offsets in Australia. For as indirect offset
is being downplayed, local content (direct offset) "will have an increasing impact
on programs, with the emphasis on the use of local prime contractors". 5
Jim Fergusson (Chapter 5) argues that, for the student of defence matters,
Canada provides an interesting case study. Security considerations are notably
absent from defence-industrial policy deliberations, not least because there is an
implicit understanding that, if attacked, the US would defend its weaker neighbour, and so competition between industrial and economic benefits is to the fore.
One consequence of this has been that offsets have served to improve Canada's
technological capability and unemployment record but at the cost of its military
capability. Again, semantics are important. Officially, Canada does not have an
offset policy but rather a requirement for industrial and regional benefits; in
other words, offsets by another name. Unlike Australia, political issues in

Canada frequently have a strong regional theme and thus the successful vendor
will have ensured the appropriate regional distribution of offsets. However,
industry is concentrated in central Canada and this makes it difficult to place


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INTRODUCTION AND OVERVIEW

7

work with existing factories elsewhere. Moreover, the establishment of a new
capability is costly and, without export markets, such capacity becomes dependent on domestic orders, thus constraining future procurement decisions. It is
also interesting to note that both Canada and Australia have had a formal offset
requirement for over two decades and that both have moved away from indirect
and towards direct offset as their preferred policy.
Another country where regional considerations play an important role is
Belgium. Like the Canadian case, this aspect of Belgian offset policy does not
appear to be particularly successful in an industrial or economic sense but a
political necessity. Wally Struys (Chapter 4) argues that overcapacity has been
and remains one of the major problems facing the Belgian defence industry and
that offsets, far from encouraging rationalisation, have served to keep inefficient
producers in business and to create additional capacity albeit in industrially
deprived regions. Struys argues that Belgian offsets have not been free goods
and that their additional cost has reduced the purchasing power of the defence
budget. Again, offsets help to maintain the defence industrial base but only in
the short term. Firms become dependent on offset work, which constrains future
procurement choices and masks industrial shortcomings. Struys argues that there
is a need to integrate offsets in to industrial development policy as a whole and
to focus on sustainable long-term goals rather than more immediate short-term

objectives.
Alon Redlich and Maison Miscavage (Chapter 15) provide a practitioner's
viewpoint. They argue that offsets should be seen as an opportunity rather than a
burden, and that with a co-operative rather than adversarial attitude, offsets can
prove beneficial to both the client country and the defence contractor. In addition to their general remarks on offsets, which (reassuringly) are very much in
line with those made by academics elsewhere in the book, the authors discuss
their recent campaign in Israel and indicate how a company, such as ITS, identifies mutually beneficial offset opportunities. Like several other countries, Israeli
offset policy encourages foreign and Israeli firms to establish very close, longterm working relationships in an attempt to improve global market access for
domestic goods. Consequently, short-term, one-off deals playa very small role
in the Israeli offset environment.
Much of the discussion of offsets is plagued by a lack of relevant information. Stephen Martin and Keith Hartley (Chapter 13) outline and discuss the
results of two industrial surveys: one looks at incoming offset work while the
other examines the impact of offsets associated with UK defence exports. These
will be of interest as the survey responses provide a rare insight into the employment, technology and competitive impact of offsets. The studies suggest that
although, financially, offsets involve considerable sums, in practical terms their


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8

THE ECONOMICS OF OFFSETS

impact is, for the UK at least, much less significant. For example, the $1.5bn
offset associated with the UK's purchase of AWACS aircraft is thought to have
generated 4804 person-years of work for UK industry while £450m of export
offset 'cost' the UK 1105 employee-years of work. It is also interesting to note
that the survey evidence suggests that offsets do cost more than an equivalent
off-the-shelf purchase and, not surprisingly, that vendors seek to include most of
this premium in the selling price. Once it is acknowledged that offsets are not

free, it then seems sensible that the benefits associated with offset should be
carefully documented. Offsets can be viewed as an instrument of industrial
policy and whether this tool is the most cost-effective way to achieve policy
objectives needs careful examination. At the time of writing, however, this is not
the UK's approach, although elsewhere offsets are part of a wider industrial
policy.
Abdullah AI-Ghrair and Nick Hooper (Chapter 9) argue that in Saudi Arabia
offset policy can be viewed as an extension of its industrial policy. Offset is not
about encouraging the vendor to purchase more domestically manufactured
goods - the Saudi industrial base is simply too small to absorb the required
amount of work. Instead, the objective is to reduce the economy's dependence
on oil by encouraging the growth of other industrial sectors through the establishment of international joint ventures. These joint ventures typically comprise
a Saudi partner, the firm that owns the relevant technology, and (often), the firm
with the offset obligation. The latter typically contributes equity capital as well
as knowledge of the type of ventures sought by the Saudi authorities and the personal contacts and local expertise necessary to facilitate the establishment of a
new venture in the Kingdom. Most of these joint ventures are not in the defence
field. This latter aspect of current policy is in marked contrast to the earliest
developments associated with the Peace Shield offset. Here, Boeing established
factories for the repair and maintenance of, inter alia, the AWACS aircraft, but
these facilities were unable to secure sufficient additional work to justify their
construction. The Saudi response to this was to continue to seek international
joint ventures as a way of introducing new technologies into the economy but to
move away from defence and into other sectors where demand is more substantial and the prospects for market growth more attractive. The emphasis is much
more on offset as a means to long-term viability rather than as a short-term stopgap to meet a deficiency of demand.
There can be few countries where offsets have made a greater contribution
to economic and industrial development than Japan. Seeking control over its
technological destiny, Japan required a local ability to research, innovate, design
and manufacture. Hence offsets have taken the form of licensed production.
These offsets have not been cheap but the Japanese government has been willing

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INTRODUCTION AND OVERVIEW

9

to pay the necessary premium for the associated benefits such as stimulating
local industry and improving the security of supply. Michael Chinworth and Ron
Matthews (Chapter 9) argue that the US has been willing to transfer technologies and thus to risk the development of new competitors for several reasons.
First, US firms receive substantial royalty payments. Second, such transfers
improve the strength of an ally against any potential Soviet threat. Third, if the
US did not grant the relevant licences, it is likely that the Japanese would turn to
the Europeans and thus acquire similar technologies, but from US competitors.
This policy has yielded a strong, technologically advanced, and increasingly
self-reliant defence industrial base. Although Japan's defence budget is likely to
be increasingly squeezed in the foreseeable future, and the defence environment
has changed considerably, the commitment to domestic defence production and
hence offset is likely to continue unabated.
Michael Chinworth and Dean Cheng (Chapter 10) argue that technology
transfer has also driven offset demands in both South Korea and Taiwan. With
the announcement of the Nixon doctrine in 1970 and the subsequent reduction of
US forces from the Asian region, both countries sought to develop an indigenous
defence industrial capacity which was seen as essential to guarantee their territorial integrity. Also, the increased sophistication of their defence industries was
viewed as a way of injecting advanced technologies into the economy as a
whole. For the US, arms sales with offsets served to strengthen diplomatic and
military ties; this was particularly important after the Nixon doctrine when many
in the region feared an imminent American withdrawal and the destabilising
consequences that would follow. With the end of the Cold War, the US has
become more concerned about the economic consequences of offsets and, in

particular, fears that such packages contribute to the growth of potential competitors. The lessons of past technology transfers to Japan remain! However, the
authors argue that both South Korea and Taiwan are unlikely to be able to
exploit these transfers to the extent that Japan was able to do. First, because
South Korea and Taiwan are attempting to develop their economies from a far
lower technological level than that which faced Japan at the end of the Second
World War and second, that this technological deficiency is exacerbated by
human resource constraints. Moreover, Japan benefitted from a far more liberal
trade and technology transfer environment than either South Korea or Taiwan,
due partly to the Western experience with Japan. Consequently, even if offsets
do transfer technologies it is unlikely that either economy will be able to exploit
such transfers to the extent that Japan was able to do so.
Jordi Molas-Gallart (Chapter 11) looks at the development of Spanish offset
policy over the past decade. The author examines the $1.5bn offset, to be met
over a ten-year period, associated with the purchase, in 1984, of 72 F-15 fighter


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THE ECONOMICS OF OFFSETS

aircraft. The objective for the offset was to improve the industrial and technological base, particularly in the defence sector, and to increase the political acceptability of spending such a large sum on a foreign product when domestic
unemployment levels were relatively high (20%). At the beginning of the 1980s
Spain's NATO membership was still pending and thus she was absent from
various major international arms co-operation fora. The author argues that it was
only through the purchase of foreign defence equipment that Spain could
attempt to upgrade the technological level of its defence industries. Particular
emphasis was given to aerospace, materials, avionics and simulators. If placing
work with Spanish firms was more expensive for McDonnell than using its usual

suppliers, then the Spanish government was willing to pay for this and set aside
$100m for this purpose.
As McDonnell-Douglas' annual obligation grew, fulfilling the offset became
more and more difficult. Molas-Gallart identifies several reasons for this. In
principle, offsets could be in any area of technological development but this
allowed the authorities to establish sectoral and regional priorities. McDonnell
submitted hundreds of projects for offset approval and the authorities, as so
often happens in other countries, were faced with the problem of deciding
whether each proposal met the conditions required to be a genuine offset.
Proposed transactions had to result in a net increase for Spanish exports to the
US. Once a project was accepted, the Management Office then had the other
familiar problem of calculating its "offset value", which involved, amongst other
things, estimating the growth in normal trade flows that the new offset caused,
and the associated Spanish value added. By the early 1990s, McDonnellDouglas was finding it difficult to meet its annual obligations, not least because
the global recession was making it increasingly difficult to find new markets for
Spanish products.
According to Gallart, these problems with the F-18 offset prompted a shift
in policy. Rather than seek offset, Spain sought direct participation in the development and production programme for the modernisation of its AV-8B Harriers.
Although the amount of business generated is similar, joint development and
production allows the tasks that Spanish industry will undertake to be defined in
advance of any final procurement decisions whereas offsets are agreed after the
procurement decision. Moreover, with joint development there is no need to
oversee offset applications.
At the same time there has been a policy to use acquisition programmes to
draw foreign partners into domestic companies. The idea here is that with an
equity interest in the profitability of the Spanish partner, the foreign company
will be more willing to share its technological and marketing skills. Moreover,
with offset the vendor's interest in placing work with Spanish firms is likely to

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INTRODUCTION AND OVERVIEW

11

decline once it has fulfilled its obligation. With an equity interest, however, it is
hoped that this will lead foreign firms to take longer term view although there is
of course nothing to stop them from selling their shareholding, although such
investments might assist US manufacturers to win other (European) orders.
Spain is not the only country to move away from one form of offset and
towards other forms of cooperation, particularly joint ventures. A similar trend is
revealed in Nicholas Antonakis' paper (Chapter 7) on Greece. The Turkish invasion of Cyprus in 1974 and the continuing territorial disputes between the two
countries, focused attention on the need to modernise Greece's defence as well
as to improve the domestic defence capability to minimise Greece's foreign
dependent and vulnerability in wartime. However, a formal offset package did
not come into being until a decade later with the purchase of 40 Mirage 2000
aircraft from Dassault. For this offset, valued at some 80% of the purchase price,
co-production and investment projects, technology transfers, the promotion of
Greek exports as well as the development of tourism, were all acceptable for
offset credit. Unfortunately, there is no publicly available information on the
success or otherwise of this package.
However, the offset agreement which accompanied the purchase of 40 F16C from the USA, signed almost three years later, was rather different. This led
to the formation of the Greek Investment Development Company (GIDC),
owned jointly by the Greek government and three US companies, General
Dynamics, General Electric and Westinghouse. The GIDC will undertake investment projects, mainly for the production of high technology goods, it will ease
and facilitate the transfer of technology to Greek firms and it will promote
the export of Greek industrial products in new foreign markets. In addition, the
offset is said to involve the co-production of air frame and engine parts to the
value of $100m. Similarly, two other major offset purchases - for four Meko200 frigates and the upgrading of the Kanaris directional firing system on

Harpoon missiles - focused on the Greek production of parts or the entire
product, either for the equipment being purchased by the Greeks or for export to
third parties.
As in the Spanish case, there seems to have been a move away from offsets
from any part of the Greek economy and towards those directly associated with
the equipment being purchased. And at the same time, the formation of the
GIDC joint venture seems to parallel Spanish attempts to draw foreign firms
into the domestic economy as a way gaining access to new technological, production and marketing skills.
Few studies outline in more detail the various forms that offset can take
better than Jean-Paul Hebert's examination of French exports (Chapter 6).
Hebert defines offset in a broad way and includes such transactions as barter, the


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THE ECONOMICS OF OFFSETS

simultaneous counter-purchase of specific goods, the counter-purchase of
unspecified industrial products and services to a specific value, technology
transfers and the provision of favourable financial loans. Hebert argues that
offsets have become an important competitive tool in the armaments market and
cites several deals where the offset package proved decisive in the choice of
which product to purchase. He concludes that as defence budgets are cut and
suppliers chase fewer and smaller orders this aspect of the competitive process is
likely to become more rather than less important.
Bernard Udis' case study of the Swiss F-5 purchase (Chapter 12) is an interesting one because it involves a number of issues which arise with many offsets.
Previously, the Swiss had licensed produced foreign designs but by the 1970s
this procurement method had become prohibitively expensive. Direct and indirect offsets offered the opportunity to buy the aircraft required and at the same

time to compensate the defence industrial base for not licence producing the aircraft domestically. For both vendor and purchaser this was one of the early
offsets of its type and, as might be expected, both sides were involved in a learning process. Swiss industry expected automatically to win contracts from US
firms and found the administrative hurdles of selling to the US military difficult
to overcome. The vendors, Northrop and General Electric, were finding it difficult to identify quickly Swiss firms with the necessary cost and quality characteristics. As is often the case with technologically advanced countries, the Swiss
wanted the offset not so much to provide jobs or to improve the balance of payments, as to assist firms that would have received orders had the aircraft been
produced in Switzerland. And as is often the case, there was the by now
common debate concerning which sales occurred as a result of the offset and
which reflected established business relations. Udis' chapter also sheds some
light on other issues associated with offset. He notes that the US vendors continued to place work with Swiss firms after the obligation had been fulfilled
although, as Udis notes, this was partly because such purchases could be banked
as offset credit. Swiss industry is still producing parts for F-5s and Udis argues
that technological spinoffs from the offset increased the possibility of Swiss participation in joint European projects. The Swiss recognise that there is a cost
premium to pay for offsets but consider that a figure of up to 10 per cent is reasonable for a well-designed offset program, and have sought offset on all major
purchases since the F-5.
US industry, with a vast trade surplus in defence equipment, incurs more
offset obligations than any other country and, given some of the alleged effects
of offsets, this has (not surprisingly) led to calls for the US Congress to limit the
offsets that US firms can offer. However, as Bernard Udis and Keith Maskus